Focus on ‘Middle Waves’ for High Probability Trades
Trends unfold in waves. There is a reversal of the former trend, a pullback or pause, another wave, pullback or pause, and so on. Common trading problems include trying to guess when a trend will reverse, and as a result entering the trade too early. Another problem is waiting until everything looks perfect before entering; while this may work on extended trends, the trend is likely about to reverse by the time everything looks perfect. Therefore, focusing on middle waves is a good strategy for newer traders, or those struggling to find profitability. Trading middle waves requires you’re patient enough to wait for the signal, but don’t wait so long that the opportunity passes you by. Here’s how to trade middle waves.
Finding Middle Waves
In order to find the middle waves, we need a context. According to Elliott Wave theory, trends typically move in a 5 wave structure, where wave 2 and 4 can be either pullbacks or consolidations. Please note this is not an Elliott Wave article though, it is just used for illustration purposes. You will see trends that have 16 waves and trends that have 5 waves, 11 waves, etc., so don’t get too hung up on the 5 wave idea. [If you do study Elliott Wave in depth, you will learn how to make sense of these contradictions. That said, learning Elliott is not required for successful trading.]
No matter how many waves there are, we do typically see this type of structure though: a big trending wave (called an impulse wave) followed by a pullback or consolidation (called a corrective wave), then another impulse wave, correction, impulse, etc. When the trend changes, the bigger impulses start moving in the other direction, indicating the trend change.
Figure 1. Basic Trend Structure
Wave 1 is the first strong move in a new direction, wave 2 is a pullback or consolidation, wave 3 is another strong push in the trending direction, wave 4 a pullback or consolidation, and wave 5 is another push in the trending direction. Waves 1, 3 and 5 are called impulse waves because they are stronger and longer than the corrective waves (2 and 4); this allows the price to make overall progress in the trending direction.
By isolating the trend and then looking for a specific set-up, the goal is to trade “wave 3,” as this is a middle wave. Wave 5 is also a good wave to trade because, as mentioned, trends often have more than 5 waves. Trading waves 3 and 5 provide the most room for error. Since trends usually make at least 5 waves, and often more, by focusing on these waves of any trend we put the odds in our favor.
While I say that we should focus on middle waves, which is often wave 3 and 5, in reality, I will trade a trend as long as it is showing strength. By strength I mean an uptrend is making a high that is significantly above the prior high and is making a swing low significantly above the prior swing low. When that is occurring, I feel confident that I am trading in the middle portion of the uptrend. If the price is barely able to make upward progress past prior highs, or a pullback is erasing nearly all (or all) the gains of the last rally, that tells me the trend is old and is more likely near the end than the middle.
Trading the Middle Wave – The Setup
In order to find a middle wave, you’ll need some experience at being able to differentiate impulse waves from corrections. Being able to do so, in real time, will help you with finding quality trade setups. Just because there is a trend doesn’t mean we just jump into a trade. The price action needs to give us very clear signals to get in. We will talk about those signals in a bit, but for now, we want to focus on being able to see impulsive and corrective waves. Figure 2 shows impulsive and corrective waves on a stock chart, along with what a trader should be thinking as each wave develops.
Figure 2. Apple Chart with Impulses and Corrections
As each wave unfolds we are analyzing that wave relative to what has happened in the past. On the left side of the chart the price was declining. But notice how the down waves become about the same size as the up waves. If a downtrend is strong, that doesn’t happen. The up waves are getting bigger compared to the down waves, until eventually there is an up wave that is bigger than the prior down wave. That tells us the trend has quite possibly shifted to the upside. We should be thinking this in our heads. We would no longer consider a short trade, but will consider buying if the corrective wave that follows makes a higher swing low. We will assume it is making a higher low if it starts to move back to the upside well above the prior low. This all happened in the chart above. The box marks the area where we are getting confirmation that the correction is likely over and that another upside move is coming.
It is possible that the price could rally a bit (after the boxed area) and then proceeded to drop right into the downtrend again, but that is why we control our risk and would get out if that happens. We can’t know for sure what will happen, we can just trade patterns that often play out…and this pattern is how downtrends often reverse into uptrends. Now, let’s look at how we would actually trade this. To make a trade we need to know our entry point, have a stop loss (risk management) and a profit target or a way to take profits if the trade moves favorably.
Trade Setups For Middle Waves
Figure 3 shows the basic trade setup. It is a zoomed in version of figure 2. Once the higher high (price moving out of downtrend) is in place, and a correction occurs, we are watching to see if that correction makes a higher swing low. It needs to in order for us to a take a trade. As soon as the market gives evidence this higher low is in place, we enter a buy/long trade. This is accomplished by waiting for the price to move above a couple of the bars seen in the pullback. I just use price data for this, although since it can be somewhat subjective you may wish to find an indicator that signals the trade more clearly.
Entry: For price action signals you can watch for the price to consolidate, and then breakout of that consolidation in the direction you expect (new trend direction). Engulfing patterns are also useful for signaling entries. You can also watch for the very small waves to signal the correction is over. In figure 3, within the box, we see a small down wave, followed by a slightly larger up wave. What did we just learn above? That little pattern probably means the price is heading higher. If the next pullback makes a higher low, buy it, because the correction is likely over and the price is moving up.
Figure 3. Middle Wave Trade Setup During Correction
Stop Loss: A stop loss is placed below the recent low to control risk. In the above chart I have placed it below the major low that occurred at the bottom of the correction. After the price consolidates and then breaks that small consolidation to the upside (see small box within bigger box), the stop loss could also be placed just below that small box. This would put the stop loss closer to the entry point.
Profit Target: A fixed target can be used, which places a target at double the stop-loss. For example, in this trade the risk is about $8 per share, so a target is placed $16 above the entry. In the chart above I placed targets at reward:risk ratios of 2:1, 3:1 and 5:1. They all were reached, but that won’t always happen. Ideally, we should have a more logical method for placing targets.
We can look to prior waves to help us establish a target. Look at the major waves leading up to this trade. The major waves were marked with red and blue arrows in figure 2. The smallest major wave was approximately $22. Since we have a trade setup and are expecting another wave to the upside, we can assume that wave will be at least $22. Once the pullback low is in place (we are assuming it is, otherwise we wouldn’t be going long), we add $22 to the low of the correction (bottom of the big box). The correction low is near $104, and if the price rallies $22, that puts a target near $126. This is also very close to the 2:1 reward to risk ratio. Therefore, on this trade, we can reasonably assume that price will give us at least 2:1 on our money. And that is based on the price wave we are trading only being as big as the smallest wave over the last year. If we want to assume the wave we are trading will be a bit bigger, than a 3:1 target can be used.
Look at the history of whatever asset you are trading to get an idea of how far the price will run. This concept can even be applied to day trading.
A profit target can also be placed just above the recent high (for a long trade), assuming that with the target placed at that level you stand to make 2:1 or more on your risk. A Fibonacci extension tool could also be used to establish an exit point.
Trailing Stop Loss: A trailing stop loss can also be beneficial. It helps reduce risk or lock in a profit if the price moves favorable, but gets you out if the price starts moving against you too much. I like an indicator called ATR Stops. It just takes a multiple of the Average True Range and plots it around the price. When the price is rising the indicator will follow below the price. When the price is falling the indicator will follow above the price.
Check that the indicator performs well with a given asset before using it. The settings should also be calibrated for each asset traded. I often use a 6-period ATR with a 3x multiplier. With some assets a 2.5 multiplier works good, and for other assets a 3.5 multiplier works best. How do you know what settings to use? Look at what settings worked best in the past for that stock. It will never be perfect, but you want the indicator to catch most of the down moves (staying red) and most of the up moves (staying green). In figure 4 we see that the indicator would have caught most of the upside rally following the trade, ultimately producing a greater than 3:1 reward risk trade before the price finally broke below the indicator.
The indicator should not be used for entry signals, rather, only as a trailing stop loss. Figure 4 also shows another trade that occurred after the one discussed above. The trend is still strong, so the next trade is also taken. If the trend is showing signs of strength, we are likely still in the middle portion of the trend.
Figure 4. Trailing Stop Loss Indicator Applied to Middle Wave
Considerations For Trading Middle Waves
Unless you are going to study Elliott Wave in-depth don’t get too hung on the “5-wave” aspect. When I trade the EURUSD on a 1-minute chart I often see 7 to 11 waves during a trend. And some days the trends only have three waves when price action is choppier. Interestingly, whether a trend has 11 waves or 3, you should end up profitable if you trade according to the guidelines outlined.
Even if a trend only has 3 waves, we still have one good opportunity in there. And then if we have a three wave trend in the other direction, we should also have at least one good opportunity there. If we end up with a losing trade in the trend transition, since our winners are bigger than our losers, we should still be profitable. I typically trade every wave in a trend (assuming I can get the entry price I want) until there is some sign the trend is in trouble (see How to Identify a Trend Change in Real Time). Or, in other words, as long as the trend is showing signs of strength I will continue to trade it. When it reverses, I trade in that direction once a proper signal develops.
Figure 5. Trends Can Last Longer Than 5 Waves
Source: My Forex Broker FXopen
In figure 5 we have an uptrend with multiple waves to trade. This trend went for 11 waves (6 impulse waves up, and 5 corrective waves in between), and showed signs of strength the entire time. The price was making significantly higher highs and significantly higher lows. Finally, near the right of the chart, the price made a lower higher and then started to fall again. That was the first sign the uptrend was in trouble.
On the chart is an envelope indicator. I no longer use, but if it looks interesting to you, you can read about it here: Four Trending Indicators to Replace the Moving Average.
Trading Middle Waves – Final Word
In this article I have talked about uptrends, but the same concepts can be applied to downtrends (and uptrends reversing into downtrends).
If you’re new to trading or struggling, try going back to basics and just trading middle waves. A strong shift in direction followed by a pullback is all we need. Our goal is simply to catch a high probability trade in the middle of the trend. I assume it is still the middle of the trend (or at least not right at the beginning or end) as long as the trend is showing strength. If we stick to trading only during strong trends, it is quite possible to win more than 60% of the trades taken while also maintaining a favorable reward:risk. This combination produces excellent profits.
Place a stop loss on every trade. Keep the profitable exits fairly simple, such as using a or 2:1 reward to risk ratio, a Fibonacci extension, or a trailing stop loss. Don’t get too hung up on “wave counting,” because unless you’re going to dedicate a lot of time and study to Elliott Wave, it will likely frustrate your trading more than it helps. Just know that trends move in impulsive and corrective patterns, and trends can last for only a few waves or many waves.
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By Cory Mitchell, CMT
For additional reading, you may also enjoy:
Day Traders: How and Why to Use a Daily Stop Loss – Controlling daily losses is as important as controlling losses on each trade, here is how day traders can control their daily losses so a single day doesn’t’t ruin their weekly or monthly income.